Both the assessee and the Revenue had filed appeals against the order passed by the Commissioner of Income- tax (Appeals) with respect to the treatment of compensation received under settlement for failure of the builder to give possession of flat within stipulated time

The assessee was an advocate by profession. During the course of the assessment proceedings for the relevant year, the Assessing Officer (AO) found that the assessee had claimed a long term capital loss on account of the receipts from builder pursuant to court order.

When asked, the assessee explained that he being interested in buying a residential flat, had entered into the construction agreement with a builder and made an advance payment of Rs. 50 lacs. The said agreement provided for a penal interest at 24% p.a. on the total amount paid in case the seller fails or neglects to handover possession of the property as stipulated in the agreement. The seller failed to honoured the obligation under the contract, hence, the assessee had to file a suit for recovery of the amount advanced with penal interest. The suit was decreed for Rs. 50 lacs with penal interest @ 24% on the principal amount. The seller approached the Hon’ble High Court against the decree of the Civil Court but the appeal was dismissed. Subsequently, the assessee entered into a memorandum of settlement and received Rs. 1.20 crores towards the full and final settlement of the entire claim which was approximately 50 per cent lower than the amount decreed by the Court.

The assessee worked out the indexed cost of the investment of Rs. 50 lacs and deducted therefrom the amount of final settlement treating the difference as long term capital loss.

The AO, however, did not agree with the assessee and opined that as per the decree of the Civil Court, the assessee should have received an higher amount but by way of memorandum of settlement, the assessee waived the income which amounted to diversion of income before it reached the assessee.

Accordingly, the AO taxed the difference between the amount decreed by the Court and as received under the settlement.

The Assessee challenged the same before the CIT(A) stating that the AO was not justified in making addition of the notional interest which have never been received by the assessee. Assessee further contended that out of Rs. 1.20 crores received by the assessee under the memorandum of settlement, Rs.50 lacs represented the amount paid towards the advance and the balance of Rs. 70 lacs represented the capital receipt. According to the assessee, since he never possessed the capital asset relatable to this transaction, the question of capital gain does not arise in the absence of any capital receipt was not taxable at all.

The CIT(A) agreed with the AO on the nature of the receipt and held that whatever the assessee received over and above the advance amount paid i.e. in the nature of interest, as such, it was liable for tax.

However, the CIT(A) did not agree with the AO on the aspect of notional interest and recorded a finding that the AO was not justified in taxing the unearned interest income on notional basis inasmuch as the parties entered into the memorandum of settlement had given up their several options of litigations and for purchasing peace entered into such a settlement. On this premise, the CIT(A) sustained the addition to the extent of Rs. 70 lacs and gave relief to the assessee in respect of the balance amount.

Before the Tribunal the assessee submitted that whatever amount was received by him under the settlement was for cancellation of the agreement or for relinquishment of rights to purchase the capital assets, as such, it assumed the character of capital receipt and in the absence of any capital gain, such capital receipt was not liable to tax.

The Tribunal observed that the relevant clause of the agreement providing interest at 24% p.a. in fact was intended to be by way of reduction of the price of the capital asset. The apartment intended to be purchased by the assessee was a capital asset and the assessee did not deal in real estate nor could such apartment be stock in as trade. The Tribunal opined that when there was a clear intention on the part of the parties that the performance or non performance shall affect the value of the capital assets, mentioning of the wording “interest @24%” was only a measure or method of calculation to quantify the receipt but was not decisive of the character of the payment. It did not partake the character of interest within the meaning of the Act.

Further, the Tribunal observed that there was no transaction of lending or borrowing nor the disputed amount was received by the assessee towards any service, fee or other charges in respect of the moneys borrowed or debt incurred or in respects any credit facility which has not been utilized. Therefore, the receipt did not fall within the definition of interest as provided u/s 2(28A) of the Act.

In view of the various decisions and inasmuch as the receipt did not fall within the definition of “interest” under the Act, the Tribunal opined that the receipt was not towards interest but only a capital receipt.

Again, the Tribunal noted that admittedly, the flat was never acquired by the assessee nor had it been transferred so as to give rise to the income under dispute, as such, it did not fall within the definition of capital gain. As held in the decision relied upon by the assessee, a capital receipt is not an income u/s 2(14) unless it is chargeable to tax as capital gain u/s 45 of the Act therefore the impugned receipt was not a capital gain and, therefore, it was outside the definition of income u/s 2(24) of the Act.

On the issue of notional interest added by the AO, the Tribunal pointed out that the Hon’ble Supreme Court held that the Income-tact Act takes into account two points of time at which the liability to tax is attracted viz. the accrual of income or its receipt, but the substance of the matter is the “income”. If income does not result at all, there can be no tax even though it is possible to reach a hypothetical income which was never materialized.

Further the Tribunal observed that the Allahabad High Court held that the earning of income whether actual or notional, has to be seen from the view point of prudent assessee and if in a given circumstance, the assessee decides to forego any income on justifiable grounds, there does not arise any question of bringing to tax any such notional income.

The Tribunal relied on the real income theory stated by the Hon’ble Supreme Court that whether an accrual has taken place or not has to be judged in appropriate cases on the principle of real income. In view of the settled proposition of law, what has to be seen is that whether the assessee had foregone any income for justifiable reasons as a prudent man or not.

The Tribunal opined that the memorandum of settlement was the result of the sellers foregoing their right to approach the Hon’ble Apex court and the assessee purchasing peace by putting end to the seemingly endless litigation. By no stretch of imagination could it be said that the assessee did not act as a prudent man in entering the said memorandum. We are convinced that all these circumstances did not suggest anything suspicious surrounding the settlement.

The Tribunal, therefore, held that the assessee not earning a particular income was not without any reason and it was not for the AO to say that the assessee should have earned such income also or that even otherwise to pay tax on such amount which was never realized by the assessee.

Held:

(i) The AO was not justified in bringing the notional interest to tax

(ii) Amount of Rs. 70 lacs received over and above the advance amount of Rs.50 lacs was in the nature of capital receipt which could be brought to tax only if the case falls u/s 45 of the Act as capital gains and since it was conspicuously a different case, such capital receipt could not be brought to tax